Hyperinflation

[An updated version of this article can be found at Hyperinflation in the 2nd edition.]

Inflation is a sustained increase in the aggregate price level. Hyperinflation is very high inflation. Although the threshold is arbitrary, economists generally reserve the term hyperinflation to describe episodes where the monthly inflation rate is greater than 50 percent. At a monthly rate of 50 percent, an item that cost $1 on January 1 would cost $130 on January 1 of the following year.

Hyperinflations are largely a twentieth-century phenomenon. The most widely studied hyperinflation occurred in Germany after World War I. The ratio of the German price index in November 1923 to the price index in August 1922—just fifteen months earlier—was 1.02 × 1010. This huge number amounts to a monthly inflation rate of 322 percent. On average, prices quadrupled each month during the sixteen months of hyperinflation.

While the German hyperinflation is better known, a much larger hyperinflation occurred in Hungary after World War II. Between August 1945 and July 1946 the general level of prices rose at the astounding rate of over 19,000 percent per month, or 19 percent per day.

Even these very large numbers understate the rates of inflation experienced during the worst days of the hyperinflations. In October 1923, German prices rose at the rate of 41 percent per day. And in July 1946, Hungarian prices more than tripled each day.

What causes hyperinflations? No one-time shock, no matter how severe, can explain sustained (i.e., continuously rapid) price growth. The world wars themselves did not cause the hyperinflations in Germany and Hungary. The destruction of resources during the wars can explain why prices in Germany and Hungary would be higher after them than before. But the wars themselves cannot explain why prices would continuously rise at rapid rates during the hyperinflation periods.

Hyperinflations are caused by extremely rapid growth in the supply of "paper" money. They occur when the monetary and fiscal authorities of a nation regularly issue large quantities of money to pay for a large stream of government expenditures. In effect, inflation is a form of taxation where the government gains at the expense of those who hold money whose value is declining. Hyperinflations are, therefore, very large taxation schemes.

During the German hyperinflation the number of German marks in circulation increased by a factor of 7.32 × 109. In Hungary, the comparable increase in the money supply was 1.19 × 1025. These numbers are smaller than those given earlier for the growth in prices. In hyperinflations prices typically grow more rapidly than the money stock because people attempt to lower the amount of purchasing power that they keep in the form of money. They attempt to avoid the inflation tax by holding more of their wealth in the form of physical commodities. As they buy these commodities, prices rise higher and inflation accelerates.

Hyperinflations tend to be self-perpetuating. Suppose a government is committed to financing its expenditures by issuing money and begins by raising the money stock by 10 percent per month. Soon the rate of inflation will increase, say, to 10 percent per month. The government will observe that it can no longer buy as much with the money it is issuing and is likely to respond by raising money growth even further. The hyperinflation cycle has begun. During the hyperinflation there will be a continuing tug-of-war between the public and the government. The public is trying to spend the money it receives quickly in order to avoid the inflation tax; the government responds to higher inflation with even higher rates of money issue.

How do hyperinflations end? The standard answer is that governments have to make a credible commitment to halting the rapid growth in the stock of money. Proponents of this view consider the end of the German hyperinflation to be a case in point. In late 1923, Germany undertook a monetary reform creating a new unit of currency called the rentenmark. The German government promised that the new currency could be converted on demand into a bond having a certain value in gold. Proponents of the standard answer argue that the guarantee of convertibility is properly viewed as a promise to cease the rapid issue of money.

An alternative view held by some economists is that not just monetary reform, but also fiscal reform, is needed to end a hyperinflation. According to this view a successful reform entails two believable commitments on the part of government. The first is a commitment to halt the rapid growth of paper money. The second is a commitment to bring the government's budget into balance. This second commitment is necessary for a successful reform because it removes, or at least lessens, the incentive for the government to resort to inflationary taxation. Thomas Sargent, a proponent of this second view, argues that the German reform of 1923 was successful because it created an independent central bank that could refuse to monetize the government deficit and because it included provisions for higher taxes and lower government expenditures.

What effects do hyperinflations have? One effect with serious consequences is the reallocation of wealth. Hyperinflations transfer wealth from the general public, which holds money, to the government, which issues money. Hyperinflations also cause borrowers to gain at the expense of lenders when loan contracts are signed prior to the worst inflation. Businesses that hold stores of raw materials and commodities gain at the expense of the general public. In Germany, renters gained at the expense of property owners because rent ceilings did not keep pace with the general level of prices. Costantino Bresciani-Turroni has argued that the hyperinflation destroyed the wealth of the stable classes in Germany and made it easier for the National Socialists (Nazis) to gain power.

Hyperinflation reduces an economy's efficiency by driving agents away from monetary transactions and toward barter. In a normal economy great efficiency is gained by using money in exchange. During hyperinflations people prefer to be paid in commodities in order to avoid the inflation tax. If they are paid in money, they spend that money as quickly as possible. In Germany workers were paid twice per day and would shop at midday to avoid further depreciation of their earnings. Hyperinflation is a wasteful game of "hot potato" where individuals use up valuable resources trying to avoid holding on to paper money.

The recent examples of very high inflation have mostly occurred in Latin America. Argentina, Bolivia, Brazil, Chile, Peru, and Uruguay together experienced an average annual inflation rate of 121 percent between 1970 and 1987. One true hyperinflation occurred during this period. In Bolivia prices increased by 12,000 percent in 1985. In Peru in 1988, a near hyperinflation occurred as prices rose by about 2,000 percent for the year, or by 30 percent per month.

The Latin American countries with high inflation also experienced a phenomenon called "dollarization." Dollarization is the use of U.S. dollars by Latin Americans in place of their domestic currency. As inflation rises, people come to believe that their own currency is not a good way to store value and they attempt to exchange their domestic money for dollars. In 1973, 90 percent of time deposits in Bolivia were denominated in Bolivian pesos. By 1985, the year of the Bolivian hyperinflation, more than 60 percent of time deposit balances were denominated in dollars.

What caused high inflation in Latin America? Many Latin American countries borrowed heavily during the seventies and agreed to repay their debts in dollars. As interest rates rose, all of these countries found it increasingly difficult to meet their debt-service obligations. The high-inflation countries were those that responded to these higher costs by printing money.

The Bolivian hyperinflation is a case in point. Eliana Cardoso explains that in 1982 Hernan Siles-Suazo took power as head of a leftist coalition that wanted to satisfy demands for more government spending on domestic programs but faced growing debt-service obligations and falling prices for its tin exports. The Bolivian government responded to this situation by printing money. Faced with a shortage of funds, it chose to raise revenue through the inflation tax instead of raising income taxes or reducing other government spending.

About the Author

Michael K. Salemi is an economics professor at the University of North Carolina in Chapel Hill.

Further Reading

Bomberger, William A., and Gail E. Makinen. "The Hungarian Hyperinflation and Stabilization of 1945-1946." Journal of Political Economy 91 (October 1983): 801-24.

Bresciani-Turroni, Costantino. The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany. 1937.

Cagan, Phillip. "The Monetary Dynamics of Hyperinflation." In Studies in the Quantity Theory of Money, edited by Milton Friedman. 1956.

The cuneiform inscription in the Liberty Fund logo is the earliest-known written appearance of the word "freedom" (amagi), or "liberty." It is taken from a clay document written about 2300 B.C. in the Sumerian city-state of Lagash.